Multiple pensions: Why your SMSF needs a ‘sacrificial lamb’

Even if you don’t need it, paying an extra pension can be a worthwhile risk management tool. Liam Shorte and Richard Livingston explain why.

Key Points

Extra pensions can help provide a ‘shield’ against unintended mistakes

New legislation means they can also provide some tax benefits

They may never be used, but they’re easy to establish

In Five super matters to think about before 15 June we highlighted the fact an extra small pension (or two) could act as a ‘sacrificial lamb’ to protect your fund in the event of a pension underpayment. Now we’ll explain this multiple pension strategy in more detail.

Don’t be surprised to hear more about the use of multiple pensions for SMSFs. They’re not only a handy risk management tool, now they’ve also got estate planning benefits.

The new rules highlighted in SMSF Alert: June 2013 ensure the continuation of a fund’s tax exemption after the death of a member and enable different account-based pensions to be paid to beneficiaries in the most tax efficient manner. For instance, accounts with large taxable components can be paid to dependants, ensuring the funds pass tax-free. Example 1 demonstrates how this might work in practice.

Example 1

Jane has a spouse and teenage daughter, in addition to an adult son from her first marriage. She intends that they each receive $300,000 on her death and wants to ensure the net (after-tax) amount is the same for each beneficiary to avoid disputes.

Jane splits her current superannuation of $600,000 – a mixture of ‘tax free’ and ‘taxable’ components – into two pensions. The first is reversionary to her spouse and the other has a non-lapsing Binding Death Nomination (BDN) to her teenage daughter.

She then makes a $300,000 non-concessional contribution to her SMSF and sets up a pension with a non-lapsing BDN to her adult son. The use of a non-lapsing BDN means the remaining trustees are bound after her death to make that payment to her son.

The spouse and teenage child are dependants, so they would receive their funds tax-free (either as pensions or lump sums and despite the fact the accounts contained substantial taxable components). Since the pension for the son is made up of only non-concessional contributions the lump sum death benefit remains 100% tax-free to the son (despite him not being a dependant).

If the entire $900,000 was held in one super account and split equally between the spouse, daughter and son, the son's share would have been subject to tax (to the extent of his share of the taxable component).

Let’s get back to the ‘sacrificial lamb back-up plan’.The premise for this strategy is that we are all human and can make mistakes in calculating or timing pension payments. There are also the unforseen, unexpected events that can cause us to miss the 30 June deadline. For instance, this year it could be as simple as the fact that 30 June fell on a Sunday – so a pension payment lodged in internet banking on 28 June probably wouldn’t have been paid until 1 July.

To set the scene, if you don’t pay the pension minimum then legally you have breached the minimum payment rules and your whole pension reverts to accumulation from the start of that tax year. The result is that all income attributable to that account gets taxed at up to 15%. Particularly in a year when the sharemarket has been strong, and large capital gains made, the resulting tax bill could be financially damaging.

The back-up plan, to avoid having all your money revert back to accumulation, is for the trustees to have two or three pensions for each member. Let’s use a simple example to explain.

Worked example

John has a $900,000 balance and takes his advisor’s recommendation to split the balance across three $300,000 account-based pensions.

The minimum pension for 2013/14 is 5% for someone John’s age (over 65 and under 75). This means John needs to pay a minimum pension of $45,000, or $15,000 from each account with the three-pension strategy.

Let’s assume John used only one pension account, was a bit of out of date on the rules, and still believed the 25% pension concession was in place. He’d think he only needed to take 3.75%, or $33,750.

His error would be more than 1/12th of the minimum pension, which means he wouldn’t be able to rely on the ATO concession to fix it. If all his funds were in one pension the entire $900,000 would revert to accumulation phase from the start of the year. If he had a 5% net income return, and another 5% in capital gains, that mistake just cost him $11,250 in additional tax.

With multiple pensions, John could choose to allocate the $33,750 to two pensions and sacrifice the third pension. This pension – the ‘sacrificial lamb’ – would have to revert to accumulation but the others would be safe. If the capital gains resided in the ‘safe’ pension accounts, this would reduce the tax bill to $2,250 (saving $9,000).

In this case, the strategy has succeeded in protecting the fund against greater damage.

Establishing multiple pensions

Setting up multiple pensions is easy to arrange. It’s simply a matter of completing a separate application form and documents for each and then tracking these separately in the annual accounts.

When you blend the estate planning and risk management strategies together they become a powerful tool that every superannuation investor should consider.

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